Lending

We try harder

Without the banks’ baggage, shadow banks find it easier to oblige customers

IN AN ENORMOUS shed on the banks of the Yangtze, China’s longest river, a remote-controlled blowtorch cuts through a thick sheet of steel. A fountain of sparks spatters outwards, watched by workers in hard hats. The machine slowly carves out a crescent of metal about a metre across. Once quenched and cooled, it is piled up on the floor with hundreds of other steel shapes, ready for assembly.

The army of welders at the other end of the shed have to shout to be heard above the whine and crackle of their torches. They will gradually assemble the individual pieces into complicated lattices. When these grow big enough to weigh 150 tonnes, they will be moved from the shed by a crane and welded to others on the wharf outside. When these components reach 600 tonnes, an even bigger crane will lift them into an adjacent dry dock. About a year from now the piles of steel cut-outs will have turned into the InterlinkFidelity, a ship 180m long and 32m wide, capable of carrying 38,800 tonnes of grain or iron ore.

There is nothing unusual about this process, except how it is being paid for: with money put up by Carlyle, a private-equity firm that is branching out into private debt as well. Before the financial crisis banks accounted for 87% of shipbuilding loans, according to Marine Money International, a firm that tracks the industry (the rest was financed by bonds). European lenders were especially prominent.

When markets plunged, however, it became apparent that shipping firms had been ordering new vessels on wildly optimistic assumptions about the growth in world trade. Yards continued to turn out ships already under construction, adding to the oversupply. Buyers tried to delay or cancel their purchases, and new orders dried up almost completely. Although freight volumes soon began to rise again, the glut kept growing and the value of ships continued to fall.

By then banks had grown leery of the business. Many had had to write off much of their pre-crisis lending to shipping firms, and revised capital and liquidity rules had made it relatively expensive to keep loans to shipowners (or any other form of long-term lending) on the books. New bank lending to the shipping industry fell from $92 billion in 2007 to $33 billion in 2009, according to Dealogic, a data firm (see chart 2). Even banks with the funds and the inclination to lend were prepared to put up perhaps only 50% of the cost of a ship rather than the 70% common before the crisis. By 2012 some Chinese shipyards were sitting totally idle, says Li Sheng of HIT Marine, a Chinese shipbroker.

As banks retrenched, private-equity firms such as Apollo Global Management, Blackstone, the Carlyle Group and KKR saw an opportunity in the low valuations of existing ships and in the shipyards begging for work. Some bought up portfolios of loans to shipping firms that banks were selling off. Last December, for instance, Oaktree Capital Management purchased €280m of shipping loans from Commerzbank, a struggling German lender that has decided to get out of shipping altogether.

Others raised money to lend to or invest in shipping firms or ships. KKR, in conjunction with other investors, has set aside $580m to lend to shipping firms. Carlyle, via an investment in a Bermudian shipowner called Interlink Maritime, has ordered 28 dry-bulk carriers like the Fidelity. In a separate venture with an American shipping firm and an Asian investment house, it has put up $750m to buy various container ships.

The shipping industry has been raising money where it can, says Campbell Houston of Marine Money, the shipping-information firm. Increasingly, that has meant relying on sources other than banks. In 2012 shipowners issued lots of bonds; last year saw a spurt of share offerings. Data are scarce, but Mr Houston guesses that private equity ploughed $30 billion into the industry last year (chart 2 shows only publicly announced deals).

“We are deliberately expanding into areas where banks are retreating,” says David Marchick of Carlyle, the private-equity firm behind the Fidelity. He mentions loans to firms in the energy and commodities business as another promising field where banks are pulling back. When Carlyle recently started sounding out investors about a fund to lend to mid-sized oil drillers, refineries, power stations and the like, it was hoping to raise $1 billion. But insurance companies, pension funds and sovereign-wealth funds are desperate to earn higher returns than those offered by the bond market, says Mr Marchick, so demand far outstripped Carlyle’s target. In the end it limited the fund to $1.4 billion, although “co-investment” by some of its big clients will bring total lending to $2 billion. Mr Marchick has many similar tales. “It’s a huge opportunity,” he concludes.

Bennett Goodman of GSO, the private-debt arm of Blackstone, another big asset manager, takes the same view: “We’re in year four or five of a 20-year run.” He predicts that GSO’s lending will grow by 10-20% a year over the next decade.

Find the market niche

It is not just borrowers from the rich world, and the manufacturers with which they place orders, that are taking advantage of this trend. David Creighton of Cordiant, which manages more than $2.4 billion in private-debt funds that lend exclusively to firms in the developing world, says poor and middle-income countries are just as much in need of alternative sources of finance as rich ones. He cites Fiagril, a Brazilian agribusiness to which Cordiant has just lent $100m. Private enterprises find it hard to obtain a loan of that size from local banks, he says, but the sum is too small to justify the expense and hassle of issuing a bond. Debt funds like Cordiant’s provide a welcome alternative.

Cordiant has lent to almost 200 firms in more than 50 countries since 2001. At first it worked only with international financial institutions such as the World Bank, which helped reassure investors. But it is gradually developing methods to protect lenders and thus attract capital more easily.

The banks’ retrenchment since the financial crisis has also given a boost to small-scale operators such as loan sharks, payday lenders, pawnbrokers and the like. The value of payday loans in Britain, for example, more than doubled between 2010 and 2012, to almost £800m. More importantly, it has encouraged a new form of grassroots finance: peer-to-peer (P2P) lending. This involves matching borrowers with lenders through some sort of online system. Lenders earn a higher rate of interest than they can get on a bank deposit and borrowers often pay less than they would for a loan from another source. The P2P company makes money by levying a fee, usually a small percentage of the money lent. Everyone gets to feel good.

The most common P2P offering is an unsecured personal loan, often to refinance credit-card debt. But P2P platforms also offer unsecured loans to businesses, as well as loans on property or against unpaid invoices, student loans and so on. Some allow investors to choose which loans they underwrite, others bundle them. Some offer insurance against defaults, others pass losses directly to investors.

The scale of P2P is still modest: the two biggest American outfits have lent only $5 billion between them, a minute share of America’s personal-loan market of $1.8 trillion. But the rate of growth is startling. At the smaller of the two, Prosper, the value of new loans agreed in March—$77m—was more than four times that a year earlier. Its lending has grown by 3,000% in eight years. Such galloping expansion is commonplace in the industry. Defaults, for the time being, are low.

Even so, bankers often express scepticism about P2P’s staying power. As volumes grow, they say, underwriting standards are bound to fall. Investors will have no real sense of the risks they are running until the next downturn arrives. Moreover, the model’s appeal relies partly on the current low interest rates around the world, which make the extra yield from P2P especially alluring to investors. When rates begin to rise again, that advantage will dissipate.

P2P firms retort that it is banks that are living on borrowed time. Their expensive branch networks and outdated technology saddle them with far higher costs than those of P2P firms. P2P’s cheerleaders also insist that the industry’s underwriting standards are just as good as banks’, if not better, in part thanks to their nimbler systems and more creative use of data. That should allow them to offer better deals while preserving their margins, whatever the prevailing interest rates. These advantages, argues Partel Tomberg of isePankur, an Estonian P2P firm, will allow P2P to wrest the consumer-lending business from banks over time. “Bit by bit,” he says, “the traditional universal banking model is being eaten up by different competitors.”

There are plenty of believers. Google last year led a $125m investment in Lending Club, the biggest American platform. Two-thirds of the money it lends now comes from hard-headed institutional investors. “There is a real risk that banks stop being the primary source for personal and small-business loans,” wrote analysts at BBVA, a Spanish bank, last year.

The same debate is taking place about shadow lending as a whole. Moneymen outside banks see their firms’ expansion onto the banks’ turf as a thoroughly good thing. They point out that shadow banks do not take deposits, in the sense of money held purely for safekeeping, and so cannot lose them in ill-conceived ventures. The extent to which they can leverage their investment by borrowing is usually strictly controlled, so the potential for cascading defaults is limited. The borrowing of America’s business development corporations, for instance, cannot exceed their capital. A move to double the limit is mired in Congress. In contrast, before the crisis big banks had assets of up to 50 times their capital.

The institutional investors that account for the overwhelming majority of shadow lending are sophisticated financial operators with diversified portfolios. The same could not be said of all bank depositors. “Our fund can go to zero,” says one big credit-fund manager, “and none of our investors would be that impaired.” They often agree to hand over their money for a fixed term, so there is little chance of a sudden and destabilising surge in withdrawals. If a deal does sour, the losses are passed directly to the lenders concerned without infecting other transactions.

For the moment P2P loans, credit funds, money markets and even the bond market have a long way to grow before they get anywhere near the scale of the world’s banking system (see chart 3). “We would not even be a small division at JPMorgan or Barclays,” says Mr Marchick of Carlyle, which has $189 billion of assets under management. Or as another shadow banker puts it, “We’re not even a pimple on the bottoms of the big banks.”

Yet their small scale suggests enormous room for growth. Borrowers certainly seem pleased to have more financing options. Yu Wei of Taizhou Kouan shipyard, where the Fidelity is being built, has nothing but praise for the private-equity firms that have entered the shipping business. They helped keep the shipyard afloat at the nadir of the business cycle, he says. That is precisely the point, argues Mr Li of HIT Marine: whereas conventional shipowners treasure their ships as they would their daughters, private-equity firms treat theirs as an asset like any other, to be bought when prices are low and sold when they are high. So private equity should help to smooth out the investment cycle—and a less volatile industry should benefit all participants.

Between two stools

Robert Hartshorne, who writes musical scores for television shows, is equally delighted by his experience with Funding Circle, a British P2P lender. He is working on an idea for an animated children’s television series based on the animals of the Chinese zodiac. A Chinese buyer is lined up, and China’s culture ministry has given its blessing. But first Mr Hartshorne has to provide a pilot episode. He and his partner initially financed the venture with £300,000 of their own savings, but when money ran short he did the rounds of the British high-street banks to ask for a loan of £60,000. Despite his successful track record in the industry and the steady stream of royalties he earns, they all turned him down. “It was like sitting opposite a dalek with a short circuit,” he says. The junior loan officers he met were all befuddled by the proposal, yet the sum requested was not big enough to merit attention from the higher-ups. With Funding Circle, he was able to raise the money within three weeks. He will never bother applying for a loan from a bank again, he says.

Even so, there are natural limits to the growth of shadow lending. For one thing, big institutional investors are a cautious lot. Allocations from their portfolios to “alternative investments”—the category that covers most shadow loans—remain small. In principle, there is a natural fit between long-term investors such as pension funds or insurance firms and the sort of long-term loans that borrowers are increasingly seeking from the shadow banking system. The premium that lenders can earn on such loans has risen as banks have backed away from them, points out Mr Goodman of GSO. Yet most underwriting expertise remains within the banks, notes John Fitzpatrick of the Geneva Association, an insurance-industry think-tank. Much as the sovereign-wealth funds and pension giants of the world would like to earn higher returns, they do not have the capacity to evaluate the creditworthiness of the businesses that might provide them. Nor, for the most part, do their asset managers.

In time that may change. But until then, asset managers will probably have to rely on banks to help generate loans for them to purchase. Unfortunately that idea has a chequered history: during the financial crisis many of the loans that banks securitised and sold proved toxic. Securitisation has since shrivelled, and much of the remaining amount is created solely for the purpose of lending to central banks, rather than sold.

Regulators are keen to revive securitisation, though they now require the originating firm to retain some exposure to prevent lending standards from slipping. Banks will have to co-ordinate with asset managers to ensure they offer the sorts of loans the asset managers want to invest in, instead of trying to dazzle them with clever financial engineering.

A partnership between Société Générale and Axa, respectively a French bank and an insurer, shows how this might be done. The pair are lending jointly to mid-sized French firms. Société Générale helps to find the borrowers, many of which are already its clients, and assesses the risk of lending to them; Axa provides the bulk of the funds. The arrangement works well for Société Générale, which is able to maintain its relationship with the borrowing firm without having to put up a lot of capital for the loan, and it allows Axa to piggyback on Société Générale’s wealth of corporate customers. But this sort of co-operation requires banks to maintain their ties with businesses in more basic forms of banking—which is by no means a sure thing.